I am a Tax Partner in WithumSmith+Brown’s National Tax Service Group and the founding father of the firm's Aspen, Colorado office. I am a CPA licensed in Colorado and New Jersey, and hold a Masters in Taxation from the University of Denver. My specialty is corporate and partnership taxation, with an emphasis on complex mergers and acquisitions structuring. In the past year, I co-authored CCH's "CCH Expert Treatise Library: Corporations Filing Consolidated Returns," was awarded the Tax Adviser's "Best Article Award" for a piece titled "S Corporation Shareholder Compensation: How Much is Enough?" and was named to the CPA Practice Advisor's "40 Under 40."

In my free time, I enjoy driving around in a van with my dog Maci, solving mysteries. I have been known to finish the New York Times Sunday crossword puzzle in less than 7 minutes, only to go back and do it again using only synonyms. I invented wool, but am so modest I allow sheep to take the credit. Dabbling in the culinary arts, I have won every Chili Cook-Off I ever entered, and several I haven’t. Lastly, and perhaps most notably, I once sang the national anthem at a World Series baseball game, though I was not in the vicinity of the microphone at the time.

Tax Geek Tuesday(?): The IRS Finally Figures Out The Real Estate Professional Rules

This is not what the Code and regulations require, and placing this burden on a taxpayer can result in incorrect conclusions. To illustrate:

A owns five commercial rental properties. He spends 600 hours on property A, 300 on property B, 300 on property C, 250 on property D, and 300 on property E. A performs no other services throughout the year. Assume that under Reg. Section 1.469-5T, A materially participates in each property, even though he does not spend 500 hours in properties B, C, D, or E (i.e., he satisfied one of the other six tests for those four properties). Because he materially participates in each separate activity, A did not elect to group the activities together under Reg. Section 1.469-9. Assume each property produces a loss for the year.

Using the Tax Court’s approach, because A failed to make the election to group the activities under -9, A must measure his qualification as a real estate professional on a property by property basis. Thus, because A did not spend more than 750 hours in any one property, he will fail to qualify as a real estate professional, and all of his losses will be treated as passive.

Under the proper approach, however, we get a very different result. Let’s go back to our steps; A must:

1. Participate in a real property trade or business as defined by the statute. As a lessor of property, A meets this standard.

2. Materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T. A materially participates in each of his rental activities;

3. The time spent participating in real property trades or businesses—but only those real property trades or businesses in which the you materially participate—must exceed the time you spend in non-real property trades or businesses; i.e., your day job. Because A materially participates in each separate rental activity, we can count the hours spent in each activity towards the total. He spent 1,750 hours on his real property trade or business (rental activities) and none on non-real property trades or businesses. As a result, this test is satisfied.

4. The time spent participating in real property trades or businesses—but only those real property trades or business in which you materially participate—must exceed 750 hours. Once again, because A materially participated in each rental activity, we can use all 1,750 hours for the purposes of this test. Thus, A has spent more than the requisite 750 hours. Because he has passed both tests, A qualifies as a real estate professional. Notice, we have not yet addressed the implications of making the “all or nothing” grouping election of -9.

5. You must materially participate in either the grouped rental activities—if an election was made under -9—or in each separate rental activity if no such election was made. Now that A has established himself as a real estate professional—and only now—we look to whether an election to group his rental activities was made under -9. This is because the election is only relevant when a taxpayer who has qualified as a real estate professional under the two quantitative tests of Section 469(c)(7), as A has, must take the next step of establishing that he materially participates in his rental activities. Despite the fact that A has not made the election, because he materially participates in each separate activity, each activity is treated as nonpassive.

By limiting the application of the -9 grouping election to after the real estate professional tests are satisfied, we get the correct result that A’s rental losses are nonpassive. The results would be equally as glaring if A were a real estate professional by virtue of a non-lessor activity.

A work in construction for 2,000 hours per year. He also owns three rental properties. He spends 200 hours on property A, 200 on property B, and 200 hours on property C. Assume that under Reg. Section 1.469-5T, A materially participates in each property, even though he does not spend 500 hours in any one activity (i.e., he satisfied one of the other six tests for those four properties). Because he materially participates in each separate activity, A did not elect to group the activities together under Reg. Section 1.469-9. Assume each property produces a loss for the year.

Under the court’s approach, because A did not make the grouping election under -9, A would have to satisfy the “more than half” and “750 hour” test for each property, which he clearly cannot do. Thus, he would fail to qualify as a real estate professional.

Under the correct approach, however, A must:

1.Participate in a real property trade or business as defined by the statute. As a builder of real estate, A meets this standard.

2.Materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T. A spends 2,000 hours in his construction business, and thus materially participates.

3. The time spent participating in real property trades or businesses—but only those real property trades or businesses in which the you materially participate—must exceed the time you spend in non-real property trades or businesses; i.e., your day job. Because A materially participates in his construction business and each of his three rental properties, we can count the hours spent in each activity towards the total. He spent 2,600 hours on his real property trade or business (construction and rental activities) and none on non-real property trades or businesses. As a result, this test is satisfied.

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Love your articles. Since section 1411 is also a fun area of the tax law, how would the 3.8% tax apply to a Real Estate Professional who does not make the -9 grouping election but meets material participation in each (say 3) rental property using one of the tests other than the 500 hour requirement. Would income be subject to the NII 3.8%?

Brad, under the final Section 1411 regulations, if no -9 grouping election is made, the taxpayer must spend 500 hours in EACH separate rental property to satisfy the safe harbor of those regulations, thereby getting to treat any rental income from the activity as not subject to Section 1411. If the taxpayer can’t get to 500 hours in each activity, he can still take the position that the activity rises to the level of a trade or business and is not subject to Section 1411, but that could be a challenge to overcome.

What is you need the -9 election in order to meet the material participation test? Say you spend 700 hours doing construction, and 200 hours each on 3 rental properties in which you do not separately materially participate. You make the -9 election. You also spend 1000 hours on other work. You need the -9 election to meet the real estate professional test and I think the -9 election applies at this first testing level, as well as when you test for material participation in rental activities.

Very helpful article, thank you. It cleared up a few cob webs on the issue. I’ve had discussion/debate on the 2000 construction example before (switch construction with real estate agent), except that my real estate agent was switched from a 1099 subcontractor to W2 employee and we could no longer meet real estate professional definition. It’s important to point out that the hours spent in construction (or any trade or business) needs to be “owned” at least 5% under the special rules of 469(c)(7)(B).

Hi Tony, great article on the subject. Very on point with clarity. I just have a question for you: Can we use the SPA rules in the material participation tests (# 4 test) to determine material participation in the real estate rental activities once we pass the real estate professional tests? SPA seem to specifically exclude rental activities based on what I read.